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Will Your 2018 401(k) Tax Break Be $18,500 -- or $2,400?

Find out what Congress wants to take away from you now.

Congress is hard at work trying to turn the Trump tax plan into legislation that can make it through both the House and the Senate, and with only a slim majority of Republican senators, party leaders have to be sensitive to the wishes of every single individual senator. With some Republicans still opposed to deficit-widening changes to the tax laws, lawmakers are looking closely at one of the most often-used tax breaks for American workers: the deduction for 401(k) contributions. Currently set at $18,000 in 2017, taxpayers would ordinarily have anticipated an inflation-linked increase in the maximum contribution they could make to their 401(k)s in 2018. Yet tax reform proponents are considering moves that could dramatically reduce the amount you'll be able to deduct from your taxes for 401(k) contributions next year.

The problem with 401(k)s

From a saver's perspective, 401(k)s are an excellent way to shelter money from taxes. The $18,000 that you can save in a 401(k) this year is one of the largest tax breaks available to average Americans, and because of increases in inflation, that number is slated to go up to $18,500 in 2018 -- if lawmakers don't cut it back.

Image source: Getty Images.

For the federal government, though, 401(k) plan contributions eat up a huge chunk of potential tax revenue. In 2016, 401(k) plans took away more than $90 billion in tax revenue, according to figures from the Joint Committee on Taxation, and that number could rise above $145 billion by 2020 under present law. With some Republican lawmakers threatening to jump ship on tax reform, those who support the plan are looking for ways to offset the immediate reductions in tax revenue that would come from lower tax rates on individual and corporate taxes, the increase in the standard deduction, and other promised breaks.

From $18,500 to $2,400?

One potential solution apparently on the table is reducing the maximum deductible contribution on 401(k)s dramatically. Recent discussions have centered on cutting contribution maximums from $18,500 all the way to $2,400, a more than 85% decrease.

What's unclear is whether the maximum would apply to all contributions or only to deductible contributions. Under current law, if your employer's 401(k) plan documents allow for Roth 401(k) contributions, you can make combined deductible and after-tax contributions up to the annual limit. Allowing Roth-style 401(k) contributions of up to $16,100 in addition to a $2,400 cap on deductible contributions would be slightly more palatable to those trying to save for retirement, but it would still take away a key tax incentive for doing so. Moreover, it would simply kick the can on government revenue concerns down the road, because the tax-free nature of Roth 401(k) earnings and distributions would potentially pose threats to balanced budgets decades into the future.

Image source: Getty Images.

Two unlikely allies

Many investors are used to having to fight against Wall Street, but on this issue, financial professionals are squarely in the same corner as ordinary savers. Industry organizations like the Investment Company Institute as well as several major retirement plan asset managers have sharply criticized the proposal, saying that anything that reduces the ability for workers to save for retirement is a long-term negative for the financial stability of the American population. Lobbyists will undoubtedly fight the measure hard in an attempt to sustain the viability and popularity of 401(k)s in the future. Yet even Wall Street faces the threat of the populist revolt that has driven the tax reform plan forward. Many will see reductions in maximum contributions to 401(k)s as affecting only the wealthy, helping to improve the current perception among many that the Trump tax plan is biased toward high-income taxpayers.

The other person fighting for investors on this is Donald Trump himself. The president tweeted Monday morning that no changes would be made to 401(k)s, noting that the deduction for retirement plan contributions "has always been a great and popular middle class tax break that works" and promising that it will stay. Yet given the president's relationship with Republicans on Capitol Hill lately, it'll be interesting to see whether lawmakers follow that directive or plow forward with a proposed reduction anyway.

Keep your eyes on Washington

It's somewhat comforting that lawmakers are apparently not talking about even more draconian changes to 401(k) plans. Earlier in the year, some lawmakers discussed taking away the tax-deferred feature of retirement saving by imposing a tax on annual gains within the plans -- even for those who didn't take any withdrawals. That measure would likely have been a death knell for 401(k)s, making them in some ways inferior to ordinary taxable brokerage accounts. The current measure at least has the benefit of sustaining the tax deferral that employer-sponsored retirement plans offer.

Nevertheless, it's important for your representatives to hear your voice about potential tax changes that would adversely affect you. Those who've put together a retirement savings strategy based on having deductible 401(k) contributions available to them could now see a huge obstacle to reaching their goals. If you're one of them, you'll want to do everything you can to ensure that the foundation of your financial security in retirement remains intact and strong both now and in the years to come.

Author

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.
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